An important question that needs to be answered ahead of taking a business to market is: Why?
“The answer is important because maybe a sale isn't the right answer for them,” says Bill Chapman a Partner at Baker Tilly. “So, if it's, ‘Hey, my partner and I aren't getting along, we want to sell the business, we both decided that, or I want to retire.’ Those are good answers. But if it's, ‘Hey, I want to take some money off the table.’ Well, maybe leverage recap makes more sense. Those are the kinds of things that we want to take a look at. If it's a, I want to pass things on, you know, to the next generation of management. ESOP is probably not a good answer, but it is on the table.”
Advisers, he said at the Minneapolis Smart Business Dealmakers Conference, should challenge a potential seller’s response because to have a successful process, the seller has to be committed.
Once it’s determined that a sale process will be undertaken, it’s best to get started right away because the more time available for planning before going to market provides ample time to erase as many of the blemishes a business might have before diligence begins.
“If there's risk profile issues, as we like to call them, in your business, there's customer concentration, or you don't have a good second management team behind you, then plan on being there for a long time,” he says. “And if you want to throw the keys over your shoulder, then you need to start planning a little bit and start moving the chess pieces around the board.”
A company that has, say, two years to do that, will likely be able to knock some of those off. But if the company has only a couple of months, then they’ll likely only be able to get their books and records in order and that, he says, might be the best they're able to do. And even then there might be issues that are so significant they’ll be difficult to clean up.
“What we've seen is on the books and records, I've yet to meet an entrepreneur who valued their accountants and their systems,” he says. “We worked once on a deal that the system had not been updated — and this is not an exaggeration — since 1983. It was written in COBOL.”
One aspect of preparing the business for a sale that’s often recommended is have a sell-side quality of earnings done.
“Earnings have quality when the reported earnings reflect free cash flow, or the economic earnings of the of the business,” Chapman says. “A good accountant can make EBITDA sing and dance if they want to.”
He says it's about validating the sustainable cash free cash flows of the business. There are some investment bankers, he says, that will not take a company to market without one because if buy-side finds something, then the seller is completely defenseless.
There are essentially five beneficial aspects of a sell-side QofE. One is it speeds the process.
“This is a process tool, not a marketing tool. It helps speed the process,” he says. “And as any investment banker or private equity fund will tell you, time is not your friend. So, you want to move through that process as fast as you can.”
The second thing the data room will have all the information, in order, that a diligence team wants to see, not what an investment banker thinks should be in there.
The third thing is a QofE serves as a dress rehearsal.
“We will be asking, as a diligence team, those same tough questions that you'll be getting asked from buyers. The example I always give us like, if I asked you, ‘have you ever been a victim of a fraud?’ It’s not the time to start staring at the tops of your shoes,” he says. “The answer is yes or no. If it's yes, what happened and what’d you do to fix it? You want to get those issues out on the table.”
And that’s the next thing a QofE does is it gets issues out on the table.
“If there's something that might be perceived as negative with your business, put it in the report, talk about it,” Chapman says. “This is something that you want to get out there, but you also want to get any mitigating circumstances out in the next sentence, so people go, ‘Oh, that's a problem. Oh, wait, no, it's not a problem.’ And then they move on, and it doesn't come up again. If they find it on their own, buyers will wave their arms in the air and go, ‘Oh, my God, we got to change the price, we got to change the structure.’ And you got to start all over again.”
The last thing, which he says is probably most important to entrepreneurs, is it can offer some comfort that the seller is not leaving any money on the table. He says in one instance, a QofE revealed that there was an error in number give for the cost of goods sold, which when corrected benefited the seller. They made the case to the buyer that this oversight had a material impact on the price, and the buyer didn't push back because they had already found it, and weren't going to say anything, and agreed to the price change.
When going through due diligence, he says there are two common mistakes that people make. One is that the seller is too aggressive with the buy side due diligence team.
“It has been my experience, for example, that when you try to intimidate the due diligence team, they wouldn't be very good if they were easily intimidated anyway, so you're wasting your time,” he says. “But if you try to do that, it's been my experience 100 percent there's a fraud there.”
The second mistake he’s seen is people being passive aggressive. In one case, he says a seller decided they wouldn’t give the buy-side team the information that they're asking for.
“People like us, diligence people, generally, we're not the glass is half empty. It's who stole the other half of the glass,” Chapman says. “To withhold information from us, we immediately go to, there is something seriously wrong here.”
